Whether you are a novice or seasoned real estate investor, you have probably wondered what can be done with failed 1031 exchanges. Every investor's income and tax situation is unique, as are the circumstances surrounding a failed 1031 exchange so this is a question best asked of your tax advisor, but there is some general information you should know about what can be done with failed 1031 exchanges.
A 1031 exchange is a provision in the IRS code that allows tax deferment on capital gains when investment or business property is sold and exchanged for like kind property of equal or greater value within very specific time frames. There are other rules, including that the propert(ies) to be sold in the 1031 exchange are identified as such in the sales contract and the proceeds from the sale are transferred directly to a Qualified Intermediary who will transfer funds to purchase the replacement property. A Qualified Intermediary cannot be a relative or in any way a party to the real estate transactions.
Next, replacement properties to be purchased as part of a 1031 exchange must be identified within 45 days of the sale of the relinquished property and the replacement property must have its sale completed within 45 days of the sale of the original relinquished property. These rules are hard and fast, and there are no exceptions to them even if the 45th or 180th days fall on a Sunday or a federal holiday.
Unfortunately, sometimes a 1031 exchange can fail because the Qualified Intermediary failed to complete the purchase transaction; this can be due to negligence, error or even bankruptcy on the part of the Qualified Intermediary.
But what can be done with a failed 1031 exchange when replacement properties are not identified or purchased in time? If the exchange has failed, then the taxpayer will owe capital gains tax. One potential way to defer the tax into another tax year happens under the Installment Sales Rules of Section 453 of the IRS code. If your property was sold 44 days before the end of the calendar year, and you had appropriate language in your sales contract you would not have access to the funds until the 46th day, which falls into the next calendar year.
The IRS does have a safe harbor procedure for investors with failed exchanges due to Qualified Intermediary default. (Revenue Procedure No. 2010-14). Talk to your tax advisor to see what your best options are.